Tuesday, October 15, 2013

But Yes Mr. President, The U.S. Has Defaulted On Its Debts

It is widely stated that the U.S. government has never defaulted. However, that is also a myth.
Catherine Rampbell reports in the New York Times:

The United States has actually defaulted on its debt obligations before.
The first time was in 1790, the only episode Professor Reinhart
unearthed in which the United States defaulted on its external debt
obligations. It also defaulted on its domestic debt obligations then,
too.
Then in 1933, in the midst of the Great Depression, the United States had another domestic debt default related to the repayment of gold-based obligations. (Update.)

The young nation had a dramatic excuse: The Treasury was
empty, the White House and Capitol were charred ruins, even the troops
fighting the War of 1812 weren’t getting paid.
***
Historian Don Hickey isn’t surprised that the default in November
1814 gets overlooked. After all, he titled his book, “The War of 1812: A
Forgotten Conflict.”

“He doesn’t know his history,” Hickey said of the president. “It’s that simple.”

To be fair, not many people do. When it comes to the War of 1812,
naval heroics and the rockets’ red glare get the ink. The failure to pay
some bondholders on time doesn’t make it into many history texts, said
Hickey, a professor at Wayne State College in Nebraska.

Investors in T-bills maturing April 26, 1979 were told
that the U.S. Treasury could not make its payments on maturing
securities to individual investors. The Treasury was also late in
redeeming T-bills which become due on May 3 and May 10, 1979. The
Treasury blamed this delay on an unprecedented volume of participation
by small investors, on failure of Congress to act in a timely fashion on
the debt ceiling legislation in April, and on an unanticipated failure
of word processing equipment used to prepare check schedules.

The United States thus defaulted because Treasury’s back office was on the fritz in the wake of a debt limit showdown.

This default was temporary. Treasury did pay these T-bills after a
short delay. But it balked at paying additional interest to cover the
period of delay. According to Zivney and Marcus, it required both legal
arm twisting and new legislation before Treasury made all investors
whole for that additional interest.

Many consider Nixon’s decision to refusal to redeem dollars for gold to constitute a partial default. For example, University of Massachusetts at Amherst economics professor Gerald Epstein notes:

Forty years ago this month, on August 15, 1971, President
Nixon “closed the gold window”, refusing to let foreign central banks
redeem their dollars for gold, facilitating the devaluation of the U.S
dollar which had been fixed relative to gold for almost thirty years.
While not strictly a default on a US debt obligation, by closing the
gold window the US government abrogated a financial commitment it had
made to the rest of the world at the Bretton Woods Conference in 1944
that set up the post-war monetary system. At Bretton Woods, the United
States had promised to redeem any and all U.S. dollars held by
foreigners – later limited to just foreign central banks — for $35
dollars an ounce. This promise explains why the Bretton Woods monetary
system was called a “gold exchange standard” and why many believed the
US dollar to be “as good as gold”. When Nixon refused to let foreign
central banks turn in their dollars for gold, and encouraged the
devaluation of the dollar which reduced the value of foreign central
bank holdings of dollars, the Nixon administration effectively “defaulted” on the United States’ long-standing obligations ending once and for all the Bretton Woods System.

The U.S. government defaulted after the Revolutionary War, and it defaulted at intervals thereafter.
***
Things were very different when America owed the kind of dollars that
couldn’t just be whistled into existence. By 1790, the new republic was
in arrears on $11,710,000 in foreign debt. These were obligations
payable in gold and silver. Alexander Hamilton, the first secretary of
the Treasury, duly paid them. In doing so, he cured a default.

***
But in the whirlwind of the “first hundred days” of the New Deal, the
dollar came in for redefinition. The country needed a cheaper and more
abundant currency, FDR said. By and by, the dollar’s value was reduced
to 1/35 of an ounce of gold.

By any fair definition, this was another default. Creditors both
domestic and foreign had lent dollars weighing just what the Founders
had said they should weigh. They expected to be repaid in identical
money.

Language to this effect — a “gold clause” — was standard in debt
contracts of the time, including instruments binding the Treasury. But
Congress resolved to abrogate those contracts, and in 1935 the Supreme
Court upheld Congress.

The “American default,” as this piece of domestic stimulus was known
in foreign parts , provoked condemnation in the City of London. “One of
the most egregious defaults in history,” judged the London Financial
News. “For repudiation of the gold clause is nothing less than that. The
plea that recent developments have created abnormal circumstances is
wholly irrelevant. It was precisely against such circumstances that the
gold clause was designed to safeguard bondholders.”

The lighter Roosevelt dollar did service until 1971, when President
Richard M. Nixon lightened it again. In fact, Nixon allowed it to float.
No longer was the value of the greenback defined in law as a particular
weight of gold or silver. It became what it looked like: a piece of
paper.

John Chamberlain argues at the Mises Institute that the U.S. defaulted on its:

Continental Currency in 1779

Domestic debt between 1782 through 1790

Greenbacks in 1862

Liberty Bonds in 1934

States Have Defaulted Also

Land values soared. States splurged on new programs. Then
it all went bust, bringing down banks and state governments with them.
This wasn’t America [today], it was America in 1841, when a
now-forgotten depression pushed eight states and a desolate territory
called Florida into the unthinkable: They defaulted on debts.

And Catherine Rampbell explains:

There were two episodes when a spate of American states
defaulted on their debts, in 1841-42 (nine states) and 1873-84 (10
states). The havoc wreaked by these state-level defaults is part of the
reason that so many states now have constitutional balanced-budget
requirements.

China Alleges that the U.S. Has Already Defaulted By Weakening the Dollar

James Grant argues:

If today’s political impasse leads to another default, it
will be a kind of technicality. Sooner or later, the Obama Treasury
will resume writing checks. The question is what those checks will buy.

***
This is the unsustainable conceit of the world’s superpower-cum-super
debtor. By deed, if not audible word, we Americans say: “The greenback
is the world’s great monetary brand. You have no choice but to use it.
Like it or lump it.” But the historical record of paper currencies is
clear: Governments always over-issue it. The people finally do lump it.”

(Indeed, the average life expectancy for a fiat currency is less than 40 years.)
As Americans, we may not agree with these sentiments. But is it us – or our creditors – who get to make the call?

Our biggest creditor – China – has said that America has already defaulted by printing too many dollars. For example:

A Chinese ratings house has accused the United States of defaulting on its massive debt, state media said Friday, a day after Beijing urged Washington to put its fiscal house in order.

“In our opinion, the United States has already been defaulting,”
Guan Jianzhong, president of Dagong Global Credit Rating Co. Ltd., the
only Chinese agency that gives sovereign ratings, was quoted by the
Global Times saying.

Washington had already defaulted on its loans by allowing the dollar to weaken against other currencies – eroding the wealth of creditors including China, Guan said.

That might be Chinese propaganda. But the point remains that the U.S.
might not be able to print money forever without facing consequences
from our creditors.

About Me

I am an investment analyst, portfolio manager, and CFA Chartholder that has worked on both the buy side and sell side in various roles including analyst, portfolio manager, and trader. I have over ten years of experience in the investment industry and characterize my investment style as having a leaning towards value. This blog will track my (and potentially guest author) opinions, managed portfolios, and investment ideas.